A front page story in the Wall Street Journal discusses how continued forced selling by hedge funds was the proximate cause of the sharp selloff of the last two days (um, the simply lousy economic news. such as lousy payrolls, horrific retail sales, no sales of credit card bonds in the last month, and similarly not-so-cheery news from overseas had nothing to do with it).

Deleveraging is destructive to asset prices. Some had hoped with the big October credit default swap settlements past (Freddie, Fannie, Lehman, WaMu) that th impetus for hedge funds dumping assets would be largely past. We weren’t so certain. First, most hedge funds have quarterly redemptions, and their investors were expected to ask for their money back in large numbers, in many cases because performance has been bad, but others factor are that investors want to reduce risk and (quelle surprise!) may need the cash. I am told typical arrangements are that withdrawal notices are due by 45 days after the end of the quarter and payment is to be made no later than 45 days after that. And unless the funds are very heavily in cash (not likely given their return ambitions), they need to sell SOMETHING to pay investors back.

However, that pressure may not be as great as thought because some hedge funds are refusing or limiting redemptions. Why this does not fatally tarnish the entire concept is beyond me (I take honoring contractual agreements seriously), but All About Alpha tells us in “Stigma of redemption gates fading fast“:

Blocking investors’ exits, even if only briefly, was once a highly unusual move that often signaled a hedge fund was on the verge of collapse, managers and investors acknowledged…That is changing now as ever-more managers and investors engage in a tug of war over who can receive money right now.”

Guess I am old fashioned. “Fool me once, shame on thee, fool me twice, shame on me.” Anyone who sticks with a firm that unilaterally changed the rules and abused their position of privilege once they have the freedom to take their money gets what they deserve.

But back to the main event. Even if hedgies have managed to hold calls for dough in abeyance, they still are more CDS related stresses in the offing to buffet the markets. The Iceland settlement is in the wings, and GM may go into bankruptcy. And any time a big hedge fund barfs and takes down a market, other firms can be forced to sell by virtue of margin calls on assets whose prices just tanked.

Hedge funds are selling billions of dollars of securities to meet demands for cash from their investors and their lenders, contributing to the stock market’s nearly 10% drop over the past two days.

The Dow Jones Industrial Average fell 443.48 points on Thursday, bringing its two-day drop to 929.49 points, its biggest two-day decline since Oct. 20, 1987. Coming amid steep drops in the retail and auto sectors, the decline wiped out a strong rally that ended on Election Day, and now the market is only 6% away from its lowest close of the year.

One of the biggest hedge funds, $16 billion Citadel Investment Group, is being asked by several major banks to post additional collateral to cover big losses on its investments, according to people familiar with the situation.

Citadel, which is run by Kenneth Griffin, was until recently considered a possible savior for troubled Wall Street firms. But his biggest hedge fund has fallen nearly 40% this year, prompting the firm to hold conversations with lenders including Goldman Sachs Group Inc., Deutsche Bank AG and Merrill Lynch & Co. that finance Citadel’s trades.

Citadel executives say the calls for more cash are a normal part of business when securities they hold fall in value, and they emphasize they have significant amounts of cash to satisfy their lenders. They say they have met all the demands for collateral….

Hedge funds have emerged as the latest serious problem in the global financial system. As their losses mount, they’re selling off securities to meet demands for cash from lenders and investors. Compounding the problem is a surge in notices from investors indicating they want out. Some hedge funds have been hoarding cash in preparation for these withdrawal requests. Hedge funds are sitting on a record amount of cash, estimated at about $400 billion, money that eventually could make its way into the market….

Withdrawals from hedge funds and from mutual funds are one factor weighing on stocks, says Mary Ann Bartels, Merrill Lynch’s chief strategist. “It’s an overhang for the market,” she says.

The recent rush of withdrawal notices to hedge funds comes as investors, including endowments, pension funds and wealthy individuals, see other investments shrink; in some cases these investors need cash to meet their own obligations. It also marks a sharp reversal of sentiment among these big institutional investors, which jumped into hedge funds and similar investments in recent years. The University of Virginia, with an endowment of $4 billion in mid-October, recently said it plans to sell $400 million of its $1.8 billion in hedge funds in the next couple of years to fulfill commitments to other investments.

The result is a downward spiral where hedge funds sell off thinly traded securities such as convertible bonds and corporate loans, driving down their prices, and leading to bigger losses and more demands for cash. Some $4.28 billion worth of corporate loans have been put up for sale in the past month, according to Standard & Poor’s. When hedge funds can’t meet the demands for cash, lenders seize their assets and try to sell them, further driving down prices and putting more funds in trouble…

“In mid-October, redemption levels were in the 5% range but all of a sudden now it’s cranking up to as high as 25% for some funds,” says Gregory Horn, president of Persimmon Capital Management, a $500 million Blue Bell, Pa., firm that invests in hedge funds. The firm has asked for about 20% of its total investments back. This “is the highest level of redemption requests” for the industry in at least 17 years, Mr. Horn says.

Some investors are withdrawing because they’re more wary of hedge funds, which fell 20% this year, through October. That beats the 34% drop for the Standard & Poor’s 500 but is nonetheless disappointing for an industry that has returned 13.8% annualized since 1990, above the 10.5% return of the S&P 500. San Francisco hedge-fund firm Farallon Capital Management LLC, which oversees about $27 billion, has seen its biggest hedge funds fall between 23% and 29% on investment declines this year, according to investors..

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So, I ask myself, what are the options for these highly leveraged, secretive, and arrogant financial species ? A TARP for hedge funds where they borrow money to cover their borrowed gambling losses ? That is what we are doing for the banks.

There are probably a number of screaming value deals available in securities. However, the markets are synthetic and opaque, not being driven by value but by de-leveraging and fraud.

At some point in the not too distant future, the curtains will have to be opened to let the sun in. I am beginning to think, the sooner the better. In the meantime, fear will reign.

*No transparency. You have no idea what the fund is doing or holding.*Leverage is a two way street. Excessive leverage is now exacerbating losses.*Exit restrictions. You cannot get out when you want to.*Whopping fees. Hedge finds take 2% off the top plus 20% of profits. That 20% of profits encourages excessive risk taking. If the fund blows up the manager just starts another one.*Hedge funds are supposed to make money no matter which way the market goes, or so they claim. To collectively be down 18%, they had to have been making one sided bullish bets on something. Where’s the hedge?’

What else does one need to know about this biz model? Like so many highly geared enterprises it worked pretty well in the good times but not so well when leverage changed from a money maker to a money loser.

In a speech given at NYU law school during March 2007, Bernanke explained:

Mr. Bernanke said the regulatory oversight applied to hedge funds was “relatively light” and acknowledged that their growing market share had raised concerns about possible systemic risks. “The failure of a highly leveraged fund holding large, concentrated positions could involve the forced liquidation of those positions, possibly at fire-sale prices, thereby imposing heavy losses on counterparties,” primarily very large commercial and investment banks, Mr. Bernanke said. “In the worst scenarios, these counterparty losses could lead to further defaults or threaten systemically important institutions,” he added.Reuters

Mr Owayda said the “2 and 20” model, whereby private equity groups charge an annual fee of 2 per cent of funds raised and take 20 per cent of any profits – was a relic from a time when most buy-out funds were much smaller.

“For some reason that 2 per cent stuck even when somebody is raising $10bn,” he said. Hedge funds, which use a similar 2 and 20 model, have already come under pressure to cut fees after the dire returns suffered by their industry this year.

The ability of the general partner to block or slow the rate of redemptions is a standard feature of almost all hedge funds. Normally this ability is triggered by redemption requests that exceed a certain percentage of the total fund. Any investor claiming to be surprised by this is either lying or failed to read the prospectus. In most cases, it is not, as Yves suggests, some sort of violation of the contract.

Hedge fund fees are ridiculous and the gating features are perhaps onerous, but they are not entirely unjustified. They can serve to protect the interests of a fund’s investors by preventing a fire sale of illiquid assets and by ensuring that all clients are treated equally. It’s also true that the gate has the convenient side benefit of temporarily propping up the fee due to the manager. Even this is not entirely without logic, however. Many of the hedge funds that were started in the last few years have no operating capital behind them. Without the fees coming in, they can’t pay the rent or the analysts. Investors could have chosen to invest only with hedge funds that could sustain themselves through hard times, but they didn’t. They chose instead to give the fund managers a sort of “insurance” that the fees would not dry up immediately. Caveat emptor.

The prevalence of gating features creates an interesting effect on any new hedge fund that might be interested in launching without a gate. If you try to start a fund like that, the lawyers who advise you will highlight to you the fact that if you have no gate but everyone else does, your clients will view you as their first source of liquidity when times get tough. You could be the very best manager in your client’s portfolio, but if he needs money, he’s going to take it from where he can, and if that means all the money comes from you and that you are going to go under, too bad for you, you should have had a gate too.

tompain is right. The redemption suspension is usually clearly defined in the prospectus and is necessary to protect the remaining shareholders from forced fire sales.

As for the transparency, with my company I invest in about 20 hedge funds and they all give me full access to their positions at any time, under the agreement that it’s for our eyes only (last year one manager wanted to stop showing us the book and we sold straight away, no second thoughts).

This is just to say that the common perception that ALL hedge funds are evil black boxes is an ignorant generalization and it’s possible to invest with very honest and transparent managers, who have great reputations and stay in touch with the investors. It’s just a matter of doing the homeworks before investing…

Let’s see: Wildcat banks in the 1830s. Railroad shares in the 1870s. Utility securities in the 1920s. Junk bonds in the 1980s. Hedgies in ASBs et. al. in the 2000s. I skipped a few but there’s a trend. One can always find fat alphas spreaders, but when they gorge in packs rather than as solitary hunters their arc is a parabolic. What’s hard to understand about that if one reads a little history? . . . Oh, I get it: the leisure class doesn’t read, either.

The massive redemptions at hedge funds points to a highly emotional response by investors. This can be a great time to get in at far lower prices. It may be worth while to look for the best hedge fund managers out there and shoot for the long term.